Chapter 5 – The Open Economy
Receipts from exports (from Canada) = about 30% of Canadian GDP, and is growing.
Open economy has international flows of goods/services from international trade, & international
flows of financial capital from international borrowing and lending Domestic spending doesn’t
need to equal output of goods/services difference between open/closed economy
5.1 – The International Flows of Capital and Goods
Y = C + I + G + X note that PE = C + I + G + X – M (represents planned purchases)
- C is the consumption of domestic goods and services (I for investment, G for government)
- X is the exports of domestic goods and services, M is imports
C, I, and G represent the consumption, Investment, and Government purchases of foreign goods
and servicef. C + f= C = totfl consumpdiondof gdods and services (same with I and G) f f f
Y = (C – C) + (I – I) + (G – G) + X = C + I + G + X = C + I + G + X – M (where M = C + I + G)
Y = C + I + G + NX where NX = X – M = output – domestic spending = Y – C – I – G
Net Foreign Investment &The Trade Balance
Y = C + I + G + NX Y – C – G = I + NX = Strade balance = NX = S – I = net capital outflow
- equality of NX and net capital outflow is an identity because of the variables
Net foreign investment (net capital outflow) = S – I = amount that domestic residents lend abroad
minus the amount foreigners are lending us
if NX > 0, we have a trade surplus & positive net capital outflow (X > M, Y > C+I+G, S > I); we are
net lenders in world financial markets, and export more than import vice versa for trade deficit
When foreigners buy domestically issued debt/assets, they’re claiming future return to domestic
capital foreigners own some domestic capital stock reducing saving (investment by Canadians)
Bilateral trade balances: nation’s trade balance with another nation (as opposed to the world)
- overall (not bilateral) trade balance is linked to a S& I since a nation can have large trade
deficits/surpluses with certain partners but still have a balanced trade overall
International Flows of Goods & Capital
If Bill sold something to a Japanese consumer for 5000 yen, then this is an export of the United
States (Bill is from the U.S.) to Japan. U.S. exports rise
If Bill stuffs 5000 yen in his mattress, some of his savings = an investment in Japanese economyU.S.
saving >U.S. investment rise in U.S. NX is matched by rise in U.S. net capital outflow
If Bill invests in Japan by using the 5000 yen to buy a Japanese bond, then some U.S. savings flows
abroad U.S. capital outflow matches U.S. net exports
Meanwhile, in Japan, C+I+G has risen but there is no change in what Japan has produced (Y)
hence, Japan’s saving (S = Y – C – G) falls for a given I. So Japan experiences net capital inflow.
But if Bill uses the 5000 yen to buy something made in Japan, then the imports and exports of the
U.S. rise equally so net exports and net capital outflow are unchanged.
If Bill exchanges his yen for U.S. dollars, the bank has the yen and can use it to do everything Ben
could’ve done so the result still holds (net exports = net capital outflow)
5.2 – Saving & investment in a Small Open economy
Capital Mobility & the World Interest Rate
Don’t assume that real interest rate equilibrates saving and investment. Economy is open now (vs.
closed) it can run a trade deficit/surplus by borrowing and lending to other countries. Perfect capital mobility: residents of the small open economy have this full access to world
financial markets. The government does not impede international borrowing/lending.
World interest rate: because of perfect capital mobility, the interest rate in the small open economy
(r) must = world interest rate (r*), + risk premium θ r = r* + θ has 3 assumptions
1. Domestic bonds and foreign bonds are perfect substitutes, with same risk, maturity (θ = 0)
2. Perfect capital mobility with no restrictions on international borrowing/lending
3. Domestic small open economy cannot influence the world interest rate (r* = exogenous)
Foreign lenders demand a risk premium if they anticipate that the Canadian $ may fall in value. To
compensate for expected capital loss, lenders demand a yield that exceeds the world interest rate.
If Canada inflates faster than other countries, the Canadian dollar has to decrease in value to keep
Canada’s exports from being priced out of foreign markets.
Interest rate differentials have SR variations, which cannot be explained by LR issues. The variations
are a result of the fact that it takes some time for international lenders to react to yield differentials.
Ex: if Canadian interest > American yield, it’ll take time for lenders to notice this & to sell bonds to
the world to obtain funds, to buy Canadian bonds. Then, the price of Canadian bonds will be bid up
enough to lower the effective yield earned by new buyers to equality with opportunities elsewhere.
Ignore temporary departures from the equal yield relationship, and assume r = r*.
In a closed economy, the equilibrium of domestic saving / investment determines the interest rate.
Hence, now, equilibrium of world saving and world investment determines the world interest rate.
There are 3 assumptions
1. Economy’s output Y is fixed by FoP and PF.
2. consumption C is positively related to disposable income C = C(Y – T)
3. investment I is negatively related to the real interest rate r I = I(r)
NX = Y – C – G – I = S – I
NX depends on variables that determine S and I. Since saving depends on fiscal policy (lower G or
higher T raise saving) and investment depends on r*, the trade balance depends on these variables.
In the closed economy, r* is where S = I (point A). But in small open economy, r* = world interest
rate. The trade balance is the difference between saving and investment at the world interest rate.
If domestic S>I, excess is lent to other countries. Otherwise, domestic investors borrow from abroad.
Trade surplus Balanced trade Trade deficit
Exports > imports Exports = imports Exports < imports
NX = Y – C – I – G > 0 NX = Y – C – I – G = 0 NX = Y – C – I – G > 0
Y > C + I + G Y = C + I + G Y < C + I + G
Saving > investment Saving = investment Saving < investment
How Policies Influence the Trade Balance
Suppose the economy is initially in balanced trade. NX = 0, and I = S.
Fiscal Policy at Home shifting the savings schedule
In a small open economy, if the government increases G, S falls since S = Y –
C – G. Hence, with unchanged r*, I remains the same& S I, & some saving flows abroad. NX = S – I, so NX rises trade surplus at home.
Graph: A small open economy starting from balanced trade responds to a
foreign fiscal expansion as the domestic S & I remain the same. R1* goes to
R2*, and the trade balance is the difference between S&I. If S > I at R2*,
there is a trade surplus increase in world interest rate due to fiscal
expansion abroad leads to trade surplus & higher net capital outflow
Occur when government budget defcit is accompanied by a trade deficit
initial NX = S – I = 0 and a balanced government budget (G–T = 0)
Then G increases (no change in T), hence there’s a budget deficit due to expansionary fiscal policy
Shifts in Investment Demand
If the government changes tax laws to encourage investment through investment tax credit, then
investment shifts to the right. S is unchanged, so some I must be financed by borrowing abroad,
which means net foreign investment is negative Since NX S – I, an increase in I implies a fall in NX.
Outward shift in investment schedule causes a trade deficit.
Evaluating Economic Policy
Net capital outflow= S – I impact of policies on NX can be found by examining impact on S or I
Policies that increase investment or decrease saving tend to cause a trade deficit, and vice versa.
Positive analysis: based on facts (vs. normative, which is more of “should”)
Trade deficit isn’t a problem, but is a symptom reflects low saving rate less for the future.
- In a closed economy low saving leads to low investment and smaller future capital stock
- In open economy, it leads to trade deficit and growing foreign debt, which must be repaid
Trade deficit is good when poor economies develop finance investment with foreign borrowing
Key: don’t judge economy from trade balance alone, but look at underlying causes of NX
trade deficit “problem” can only be solved by some combination of reducing government budget
deficit, increasing its rate of private saving, and decreasing its rate of investment spending.
Marginal product of capital MPK = aA(K/L) more capital = less valuable per extra unit
- a is the parameter that determines capital’s share of total income
- A represents the state of technology
- a < 1 always, which means a – 1 < 0, which means that an increase in K/L decreases MPK
Capital does not flow to nations where it should be most valuable, but to capital rich countries.
- There are important differences among nations other than accumulation of capital
- Poor nations have inferior production capabilities (lower A) due to technology & education or less
efficient economic policies thus, there’s less output for given inputs of K & L hence, even if
capital is scarce, it’s not valuable in poor nations, since it doesn’t produce much anyway
- Property rights aren’t enforced in poor countries. So even if capital is valuable in poor nations,
both foreign & local investors avoid investing there simply because they’re afraid of losing it. 5.3 – Exchange Rates
Exchange rate between 2 nations = price at which those nations’ residents trade with each other
Nominal: (e) relative price of the currency of 2 countries. (ex: 100 Japanese yen for 1 dollar)
- Under a flexible exchange rate system, e is determined where foreign demand for currency =
supply of currency (see graph) equilibrium exchange rate can fluctuate to shifts in S and D
Real: relative price of the goods of 2 countries. Tells us the rate at which we can trade the goods of
one country for the goods of another A.K.A. terms of trade
- Real exchange rate = Nominal exchange rate x price of domestic good / price of foreign good
- Ex: if Canadian toy costs $20, and a similar Japanese toy costs 2400 yen, and $1= 100 yen, then the
Canadian toy costs 2000 yen. 2000 yen vs. 2400 yen means Canadian toy is 5/6 s of what the
Japanese toy costs. In real terms, 6 Canadian toys for 5 Japanese toys.
- Rate at which foreign & domestic goods are exchanged depends on prices of goods in local
currencies, and on the rate at which the currencies are exchanged.
- Real exchange rate = e x (P/P*)
o e is the nominal exchange rate (yen per dollar) relative price of domestic goods
o P is the price level in Canada (domestic), and P* is the price level in Japan (foreign)
Real Exchange Rate & the Trade Balance
If real exchange rate is low, then domestic residents import less, and
foreigners want our goods (since they’re cheaper). Hence, quantity of net
exports demanded will be high. (and vice versa for high exchange rate)
NX = NX( ) represents the relationship between real exchange rate & NX
- States that net exports are a functio